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The price of equity risks

Apr 19 2017 15:51

Schalk Louw

Schalk Louw, portfolio manager at PSG Wealth

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I’ve referred to the term “danger pay” on previous occasions as a concept that especially soldiers are quite familiar with. Danger pay is that extra payment in exchange for their willingness to, amongst other things, do service in extremely dangerous areas. This type of payment may sound very attractive, but it’s of crucial importance that soldiers remain aware of the possibly huge price attached to danger pay. They have to be willing to sacrifice their own lives for a few thousand rand extra a month.

In the investment world, we are also familiar with danger pay, or risk premium, and although it won’t necessarily claim your life, it’s definitely something that you should be aware of at all times, especially when compiling your own personal share portfolio.

The famous mathematician Benoit Mandelbrot illustrated it best when he said, “Winning strategies tend to have a brief half-life.” The main reason for this is due to the dynamic nature of stock markets. The moment a mispriced opportunity arises, clever strategies are used to identify and isolate them. However, this isn’t possible all the time.

Graph 1 below clearly shows the difference in danger pay or risk premium attached to shares, versus the more risk-free environment of the money market. The average of this difference over the last 52 years used to be approximately 9 percentage points, which meant that you would have earned 9 percentage points higher returns when compared to the RSA TB three-month rates, in exchange for taking higher risks. An interesting statistic indicates, however, that even though you would have performed better if you were invested in shares over the 52 years in question, you only would have managed to outperform RSA TB three-month rates by 9 percentage points or more for 25 out of these 52 years (48% of the time).

When we adjust this graph to reflect the 12-month rolling returns (graph 2 below), the picture doesn’t change much at all. Out of the 613 months, local shares only managed to outperform the risk premium 301 months of the time (or 49% of the time).

What this tells us is that investors weren’t rewarded for the risks they were taking over 50% of the time. In fact, the huge dips in the graph show us that these risks sometimes ruined investors, which unfortunately is the downside of taking risks.

I cannot say with any amount of certainty what the future risk premium will be, but I am convinced that it will keep on showing the same up-and-down movements.

The problem is that we don’t know when those up-and-down months will occur, which means that as investors, we have to be willing to take the bad with the good. What I mean by this is that if you were invested in local shares full-time over the past 52 years, your annual returns would have totalled 16% per year. If you became uneasy with the risks at times, tried to call the peak of the market and missed the 15 best months (2.4% of all months) in the process, your annual returns would have dropped to roughly 11.5% per year.

Unfortunately, the picture becomes even bleaker if you had managed to miss out on the 50 best months, which would have resulted in your earnings dropping to below 5% per year. In other words, it would then have been better to stay in the less risky environment of the money market.

My message this week is simply this: the best approach to an investment in shares lies in the fact that you should never try to earn “danger pay” if it doesn’t fall within your personal risk profile, and more importantly, that you should measure your success over the long term.

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 13 April edition of finweek. Buy and download the magazine here.